What Makes A Good Business?

What Makes A Good Business?

Warren Buffett’s has built a multi-billion dollar fortune by following a simple investment mantra. He only buys good companies at attractive prices.

This approach seems simple at first, but defining what constitutes a good company isn’t easy.

Luckily, the Oracle of Omaha has spoken about this subject at length in the past.

In 1991, he explained that one of the simplest tests one could use to a establish the strength of a business, was to ask “how long does the management have to think before they decide to raise prices?”

He went on to add:

“You’re looking at a marvelous business when you look in the mirror and say “mirror, mirror on the wall, how much should I charge for Coke this fall?” [And the mirror replies, “More.”] That’s a great business. When you say, like we used to in the textile business, when you get down on your knees, call in all the priests, rabbis, and everyone else, [and say] “just another half cent a yard.” Then you get up and they say “We won’t pay it.” It’s just night and day. I mean, if you walk into a drugstore, and you say “I’d like a Hershey bar” and the man says “I don’t have any Hershey bars, but I’ve got this unmarked chocolate bar, and it’s a nickel cheaper than a Hershey bar” you just go across the street and buy a Hershey bar. That is a good business. The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business.”

The other marker of a good business, Buffett continued, is how essential the firm’s product is to customers. As an example, he presented the case of the then highest-priced newspaper in the United States, the Daily Racing Form:

“It sells about 150,000 copies a day, and it has for about 50 years, and it’s either $2.00 or $2.25 (they keep raising prices) and it’s essential. If you’re heading to the racetrack and you’ve got a choice between betting on your wife’s birthday, and Joe’s Little Green Sheet, and the Daily Racing Form, if you’re a serious racing handicapper, you want The Form. You can charge $2.00 for The Form, you can charge $1.50, you can charge $2.50 and people are going to buy it…

It’s like selling needles to addicts, basically. It’s an essential business. It will be an essential business five or 10 years from now. You have to decide whether horse racing will be around five or 10 years from now, and you have to decide whether there’s any way people will get their information about past performances of different horses from different sources. But you’ve only got about two questions to answer, and if you answer them, you know the business will make a lot of money.”

Companies that meet both of these criteria are rare. Nonetheless, they do exist.

The sorts of competitive advantages that define a good business can vary from company to company. Some firms benefit from network effects whereby the consumer is drawn to the offering due to the number of other users. Facebook is perhaps the best example of this at the moment.

Other advantages include size and scale. Firms such as MasterCard and Visa fall into this bucket. These firms also benefit from network effects. Although, one could argue that neither firm has the pricing power Buffett described in 1991.

Apple and Coca-Cola, which are two of Buffett’s largest investments currently, exhibit both of the qualities the Oracle of Omaha described in 1991. The two groups have complete pricing power, and Apple’s services are vital to its customers.

Finding these sorts of business has always been hard and unfortunately, it’s only getting harder. We live in an age of extreme disruption, and even the market’s largest companies are struggling to keep up with smaller peers.

One of the easiest ways to identify a high-quality business was to look at its profits margins and return on capital employed.

While these figures can still be useful in evaluating an enterprise, one also needs to pay close attention to qualitative factors such as the value achieved by customers and management capital allocation skill.

Finding a business with pricing power is just the start of the process. Over the next few weeks I’ll be looking at a process and framework investors can use to uncover these hidden gems.

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